With the advancement of technology and growing businesses, the SME loan sector is witnessing a boom. SMEs have a significant impact on the GDP of an economy and thrive on running efficiently using the best possible resources. However, they may experience situations such as low growth trends or recovering from losses that could require additional funding. Businesses may also need additional funds to improve growth, add a new product or feature, or penetrate new markets.
Lenders offer extensive support to fund SMEs by granting additional financing in the form of loans. Enterprises can avail of an SME loan by pledging a portion of their assets as collateral. The assets pledged as collateral can be categorized under the following heads
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Real estate
Real estate is one of SMEs’ most widely used collaterals to avail a loan. An enterprise can pledge real estate as a loan guarantee, such as manufacturing units and residential or commercial property.
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Financial assets
Financial assets that can be pledged by businesses include bonds, stocks, debentures, and trading accounts.
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Tangible assets
Businesses can pledge inventory or machinery to provide a guarantee for the loan.
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Intangible assets
Businesses may hold their intangible assets as a part of the collateral, such as copyright, patent, and trademarks.
Many SMEs have started taking loans to run their businesses effectively. Collateral may serve as a basis to get more attractive loan terms. Collateral also plays a vital role in taking a loan – the most important being minimizing credit risk. Let us understand the role of collateral while granting loans to SMEs.
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Loan Application Approval
Lending institutions may consider various factors to determine the risk involved in granting loans to a business. SMEs can apply for a business loan online. However, businesses applying for loans may not get their application approved each time, as lenders may sense some risk in the returns or future cash flows and may reject their application. Collateral helps lenders evaluate the risk associated with granting a loan. With collateral, lenders would be more forthcoming to give a loan, knowing that they can recover their losses in case of a default. Businesses can also make their loan application stand out by providing collateral, increasing the chances of their application getting approved. In addition, while planning to take loans, businesses can use the Business Loan EMI calculator of their preferred lending institution to compute their monthly budgets and expenditure effectively.
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Reduced Losses for Lenders
Lenders can recover their losses by seizing the collateral if an SME is unable to repay the loan amount. As a result, collateral works as a shield that safeguards lending institutions from making losses.
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Reduces moral Risk
As SMEs seek to avail of loans to run their operations, they provide documentation regarding the purpose of the loan. At times, lending institutions may not have confidence that the enterprise is using the allotted funds for the purposes stated in the loan application. Lenders may hesitate to grant loans to high-risk businesses or businesses that depict irregular or uncertain cash flows. In such cases, collateral guarantees the lenders that the business will repay its debts.
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Narrows down the systematic risk
If an SME cannot repay the loan amount, lenders have a right to seize the collateral, which saves them from making losses. This, in turn, helps the lenders to run their operations smoothly and return money to the depositors as they need. Suppose the lending institution faces a considerable loss. Its depositors, who have saved their money with the lender, would also face losses due to the immediate unavailability of funds. It gives rise to systematic risk.
On the other hand, if the lending institution witnesses a substantial default on a collateralized loan, it can sell the collateral to attain the gross proceeds. The lender can use the proceeds as payouts to the depositors, thereby averting such systematic risk.
Conclusion
SMEs can seek loans from lending institutions to restore liquidity in their businesses. Taking collateralized loans helps businesses significantly, such as to attain greater chances of application approval or to attain attractive loan offers and lower interest rates. Collateral minimizes the risk of the lending institutions and safeguards systematic risk.
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